Companies with huge debts on their books will suffer the most from the rising interest rates

May 23 - 29, 2005

By raising the yields by around 100bps in the last 3-month and 12-month T-Bill auction the SBP has removed all doubts that interest rates are going to stick around the corner for long. The upward direction has been set with great pace and visible very clearly. With SBP raising interest rates by huge quantum to fight inflation, several sectors of the economy will face increased financial charges. While some may not face the impact, some are actually benefit from the hike in interest rates.

According to a report by Alfalah Securities, short-run economic growth tends to follow cycles. The objective of any central bank is to ensure that the cycles are minimized and the economy remains on a long-run growth path. Interest rates are one of the monetary policy tools available with the central bank to meet this objective. When the economy is in a recession, the central bank reduces the interest rates to spur growth in money supply. This reduction in interest rates gives incentive to increase domestic spending. Indeed, the reduction in interest rates in Pakistan led to a boom in domestic demand (currently at 56% of GDP). The boom in consumption pulled up demand for industrial products like automobiles, consumer durables, housing, cement, steel and services etc.

The growth in industrial sector improves urban household income, which leads to growth in the services sector. The growth in GDP improves government's tax revenues and allows it to provide more subsidies and incentives to the agriculture sector. The growth in consumption demand leads to increase in capacity utilization in the industrial sectors. However, the growth in money supply (due to higher demand) leads to inflation as there is more money chasing fewer goods. At this time, the central bank has to ensure that inflation is curbed (by raising interest rates) and at the same time the growth momentum is not damaged.

According to a World Bank study a rise in inflation to 10% leads to a reduction in GDP growth by 0.4%. How does this come about? Rise in inflation 1) creates uncertainty in investment, 2) leads to an increase in the cost of doing business, 3) erodes purchasing power and hence reduces consumption demand and 4) leads to political turmoil by widening income disparities. If inflation remains unchecked, the steam in the economic momentum would fizzle out. To solve this problem a prudent central bank raises the interest rates to reduce the money supply and control inflation. This is indeed what the SBP has been doing.

If the rise in interest rates is successful in curbing inflation, its impact on economic growth should be positive. However, there is a time lag between rise in interest rates and reduction in inflation. During this time lag, a rise in interest rates would play negatively on consumption demand and industrial investment. However, in Pakistan the industrial sector has already invested heavily for BMR. The production from this capacity expansion would come about by the next year and would be propellant for the growth in industrial production.

Equities prices and fixed bond yields generally tend to move opposite to each other. Empirically for KSE, a reduction in money supply leads to a dampening of growth of the index. So rising interest rates should theoretically, dampen the market. However, the direction of the equity prices and indeed the long run growth is dependant on factors like economic growth, political outlook and corporate earnings. All these three factors are positive for Pakistan. Hence, the doomsayers have less ground to support their view.

InvestCap has analyzed the impact of rising interest on listed companies. According to their report, companies with huge debts on their books will suffer the most from the increasing interest rates. Usually, companies have debt with floating rates linked to KIBOR or T-Bill. Of late, most of these debts come without a cap or a floor, which further exposes these companies to the interest rate risk. Of course then, as rates rise, so do their financial charges.

Cement sector companies will have to suffer quite a burn as many cement companies have borrowed huge amounts of money to materialize the expansions.

Gas distribution companies will also face increased cost because of their ambitious capex program. As of March 2005, the combined debt to equity ratio of the two Sui companies stood at a high 50:50.

Fertilizer companies, Textile, PSF and Airlines will also experience a hit due to the increasing interest rates, as they too carry big loans on their books.

In the telecom sector, the giant is almost debt free. However, the smaller new start-ups are literally leveraged to the hilt. These small companies will consequently have to bear the price of being leveraged.

Banks will gain from rising yields on investments and advances. Although deposit rates have also started to rise on fixed term deposits, most of the local deposits still lie in the current and saving accounts, where returns are pretty low. The greatest benefit will go to the banks that have more space left to indulge in higher yielding securities now.